Using Blockchain Technology
All functions of the central depository within transactions (settlements, accounting, storage and maintenance of assets) are now performed using blockchain technology. They are based on such an aspect of blockchain technology as digitalization or tokenization of securities. CSDs must adjust to the tokenization of securities in order to keep services relevant in the new financial era.
The popularity of crypto custody is supported by data from research firm CB Insights, with $3.9 billion in investment in crypto custody from the beginning of 2021 to the third quarter . This figure exceeds the total volume of investments in the direction for the previous six years.
What is tokenization?
Tokenization refers to the digitalization of securities or their transfer to a digital format. Ownership of a security is confirmed by a digital token registered in a distributed ledger, and is transferred only through the transfer of a token (and vice versa).
Tokenization is the next stage in the evolution of the method of clearing and settling securities.
Previously, we relied on intermediaries such as central depositories and custodian banks to account for securities transactions. Now this function has passed to the program code. Thanks to the transparency of distributed ledger technology (DLT), which underpins decentralized finance and tokenization, transactions, their clearing and settlement are now made directly between the buyer and the seller.
Great Feature of Tokenization
Facilitating direct transactions without an intermediary is a great feature of tokenization. The exchange takes place in real time using the so-called Internet of Value technology, outside of any closed ecosystem and without the use of old technologies using SWIFT messages.
It is impossible to build the future of finance using the old infrastructure. The once-popular CDs and VHS have given way to the modern technology that created Spotify, Uber, and Netflix. So in the field of finance, Ethereum, a decentralized financial platform, is replacing old technologies.
To say that the future of clearing and settlement lies with the tokenization of securities is an understatement. Real estate Tokenized securities compete with might and main for money with traditional financial instruments.
The author of an article published in the Future of Finance, referring to data from one of the largest infrastructure organizations in the financial market, wrote that in the next five to ten years, platforms for the circulation of tokenized securities may be equal in size to traditional stock exchanges.
How does tokenization threaten central depositories?
Central depositories perform four main functions in a transaction: issuance, settlements, accounting and storage, asset servicing. Tokenization threatens each of them.
Let’s take a release for example. Instead of issuing securities on a traditional stock exchange using the current infrastructure that depends on intermediaries such as central depositories, companies can issue tokens by transferring them to digital wallets.
An investor can independently store tokens in a digital wallet or transfer them to a custodian for storage. Many new custodians have appeared on the market, whose activities are regulated by the laws of their jurisdiction and which already offer services to investors in cryptocurrency. It is only natural that they will expand custody services to private keys of security tokens and tokenized securities.
About the benefits of tokenization
One of the main advantages of tokenization is fast settlement of transactions, since the exchanges on which tokenized securities are traded operate 24/7. Tokenized securities allow for fractional ownership, which will help them crowd out legacy mutual funds.
There are other benefits to tokenization as well.
Exchanges that trade tokenized securities attract more liquidity and give investors access to previously untapped sources of liquidity from around the world.
A great example is Liquid share, a fintech company. Liquid share created securities tokens for private companies that could not list securities on traditional stock exchanges.
Expanding the geography of access to liquidity
Tokenization gives investors access to liquidity outside their home country. Now each investor must have an account opened with a broker or custodian bank of the country on the stock exchange of which the investor plans to trade in shares. This increases costs for foreign retail investors. In addition, the settlement processes for transactions through the custodian are slow and complex.
Since the tokenization of financial instruments eliminates the need for an intermediary, anyone, anywhere in the world, can buy and sell tokenized securities. An internet connection is enough.
Reduced operating costs
The main feature of the Ethereum blockchain platform is smart contracts. With their help, the terms of the transaction are recorded in the program code of the transaction.
Thanks to the open source ledger, which is one of the features of blockchain technology, anyone can see the same version of the ledger in real time.
Real-time tracking of trades is a constant requirement for issuers in traditional financial markets. Until recently, few contributors could offer such functionality. This reduces transparency in traditional financial markets.
Conducting a real-time ledger audit enhances the ability of regulators to ensure the integrity of transactions.
Increasing access to financial services
The issuance of tokenized securities reduces the direct costs of both the issuer and the investor. This expands access to financial services as the barrier to investment in crypto markets is lower than in traditional financial markets.
The Ethereum standards make it as easy to exchange value over the Internet as it is to exchange ordinary information. The Internet of Value is public and accessible, interoperability between new asset classes will become a reality.
We call it “money lego” and matching. It is achieved through open source codes that form the basis of decentralized finance protocols. This is not possible in traditional financial markets, so change is inevitable.
New asset classes
Tokenization brings new asset classes to the market: art, real estate and collectibles, as well as new forms of money. This gives CSDs the opportunity to offer investors custody services for new asset classes.
How does ConsenSys help in creating the future of finance?
Decentralized finance is the basis of a new financial system that uses the Ethereum platform as an Internet of value within the framework of the Web 3.0 concept. ConsenSys creates such a new financial system.
ConsenSys is offering investors two wallets. The MetaMask Institutional Wallet allows cryptocurrency investors and market makers to act on behalf of investors in the decentralized finance ecosystem.
How can CSDs become agents of change?
The paradigm shift in the financial markets, accompanied by the transition from the old systems to the new ecosystem of decentralized finance, opens up huge opportunities for central depositories to become agents of these changes.
Some traditional financial institutions are already capitalizing on this opportunity. This proof of concept is one example of how the two worlds of finance will eventually coexist.
As Natural Monopolies
It took more than 10 years to move from physical share certificates to paperless certificates. As natural monopolies, central depositories had no competitors. This allowed them to change in time and keep up with the technological changes that the dematerialization of securities required.
Many CSDs rely on existing legislation to protect their monopoly status. However, many European countries are leading the way in developing a new legal framework that promotes tokenization.
Now they can use their associations to discuss how to steer innovation in the right direction.
Financial Market Infrastructure
CSDs have the capability to develop an international industry standard regulated financial market infrastructure using DLT and open source technologies to achieve interoperability and economies of scale within the Internet of Value.
In this way, they will compete with new service providers, which over time will become not just cryptocurrency exchanges, but will offer all possible types of tokens on their platforms.
Asked about the role of infrastructure organizations in transforming the securities industry, Nadine Chakar, Head of Digital at State Street, said: “Only if they transform themselves… If they contribute to our transformation, we will fully support them, but we also cannot let them slow down our own transformation.”